Christine Benz: Hi, I am Christine Benz for Morningstar.com. Bond funds have held up relatively well amid the recent stock market turmoil, but there has been a broad variation in performance. Here with me to discuss some of the key trends that we've been seeing in bond-fund performance is Eric Jacobson. He is director of fixed-income research for Morningstar.

Eric, thanks so much for being here.

Eric Jacobson: Glad to be with you, Christine.

Benz: So, Eric, let's start with what have been the best performers. We all know that Treasuries, particularly long Treasuries, have done really well. Have there been any other pockets of strength within the bond-fund realm?

Jacobson: Well, I think the best way to think about it is, it really just traces to whatever bond categories have funds in them with the lot of Treasuries and with the lot of long Treasuries. So it's just that simple.

Benz: So the Standard & Poor's U.S. debt downgrade really didn't flap the Treasury markets at all. They held up just fine.

Jacobson: That's right. I think the confusion from a lot of people was that perhaps they hadn't expected the fact that the market was really going to react in terms of what this said more broadly about the U.S. economy and the U.S. financial system. And oddly enough, despite the downgrade itself, the bigger fear is that those more sensitive sectors are going to be affected more severely.

Benz: OK. So, the more Treasuries you had, the better you did. The longer duration you were within Treasuries, the better you did. How about weak pockets in the market? What were the key areas of trouble for bond-fund investors?

Jacobson: Sure. Well, it pretty much went across the board, anything with credit sensitivity, whether you're talking about high- or low-quality corporate bonds or bank loan portfolios, pretty much all of that. And then, unfortunately, any funds that had large concentrations in those and didn't have very much in the way of Treasuries to act as a ballast felt some of that, as well.

Benz: So, some of the diversified funds, some of the multisector funds, it looks like some of those obviously have some lower-quality bonds. I know that's some of those categories struggled, as well.

Jacobson: That's right, and a lot of managers in those categories--including multisector, intermediate-term bond, which is more of the core part of the market--they have been, as you know, migrating into more credit-sensitive areas. These are areas that we say have spread or spread risk. In other words, a yield spread over Treasuries as a way to counter the effect of buying very, very low-yielding Treasuries. It wasn't a disaster frankly for most of them. But at this moment in time for this very short stretch, it wasn't the right place to be.

Benz: So, Eric, I want to dig into that question a little bit more because some of the intermediate-term funds that you've just discussed have had relatively weak performance and as you said, it was because they were underweight, if not altogether out of Treasuries. You mentioned that the low yields in Treasuries were what pushed a lot of managers out. Are they regretting that decision ,or are they still comfortably with that positioning, even given what we've seen recently with Treasuries really being by far the best place to be?

Jacobson: Yeah. I think you know certainly if you were to pull them today, they would probably tell you that it hasn't been any fun to be at the back-end of the pack in a rally of Treasury bonds. The nuance of it is, is that many of them actually started building up their Treasury stakes, just little by little from where the real lows that they had been a few months ago when it seemed to them that not only valuations were poor, but that the likelihood of rising rates was a little higher. Most of them began to feel differently about that as economic indicators started coming in a few months ago that looked weaker and weaker.

So, a number of these managers started letting their Treasury stakes build up slowly and letting their durations extend from where they were. So for example, I mentioned in the piece that I wrote recently that PIMCO's Bill Gross had gotten up to I think a net percentage of 9% in terms of the market value weighting of government bonds, including Treasuries and agencies, by the time that this happened and the duration on PIMCO Total Return had drifted up some. We've seen something similar among other funds, as well. The fact is, though, as that by the time we got to this rally, most of them were still underweight, pretty severely, and shorter in terms of duration than the index.

So, I think the way many of them look at it now is that they believe that the valuations are worse even than they were before but the economic situation has apparently become more clear to the point, where they are not as worried about rising yields coming from an economic shock on the upside as they were. And I think some of them are just trying to get a little closer to the center of the market to avoid this problem of being away from it in an unexpected rally. Oddly enough, it's sort of a tail risk in the sense of they run the risk of being too conservative and missing out on important rally as a way to balance out things in a portfolio.

Benz: Eric, you touched on the index a few times, so the Barclays Capital Aggregate Bond Index is the widely cited benchmark for a lot of these core-type funds. We've been discussing the relevance of that index whether managers that you talk to still think of that index's construction as making sense for fixed-income portfolios, given how heavy on government bonds it is. Let's talk about your take on that question.

Jacobson: Sure. Well, the construction of the index, and pretty much all other indexes like it, has been a topic of discussion, debate, and controversy for years and years. The difference is that up until now managers still tended to manage in the same sectors that the index was in, if not exactly in the same proportion. So it still served a pretty good purpose. With so much Treasury issuance and mortgage issuance we're at the point now where so much of the index is really backed by the U.S. government--even though mortgages do have a considerable yield spread over Treasuries--that managers don't necessarily feel it is as relevant an index.

If for no other reason than the fact that you don't necessarily want to be benchmarking bonds against issuers that are just profligate borrowers. In other words, is that where you want to be putting your money with the most indebted borrowers? It's a little bit of a grand dramatic point; we can argue about the U.S. government so on and so forth. But this is true worldwide now, and it affects how global indexes look, too. Japan is very large in global indexes and this has been a problem over there for years because global and foreign world-bond fund managers have not wanted to have very much in Japan's bond market.

So now what we're seeing, as we talked about, is you've got these core bond managers and also multisector managers who are investing in areas that aren't really either in the index or well-represented; high-yield, for example, does not exist in the regular U.S. aggregate index nor do foreign currency-denominated bonds, both of which have become a lot more popular across the board with core bond-fund managers.

Benz: So have bond-fund shops come up with any alternatives to sort of the current index construction, which is roughly equivalent to kind of the market-cap weighted construction that stock indexes use? Has anyone come up with a better option?

Jacobson: Sure, there have been a few moves in that direction. I don't think it's fair to call it a mature shift at this point. Barclays and some of the others have started rolling out what we would probably call GDP-weighted indexes. They work a little easier in that respect at the global level because you can weigh countries based on the size of economies in theory.

PIMCO was actually one of the first which was really interesting because it's unusual for an asset manager to come up and try and float a index, if you will, but the firm did it with its Global Advantage Index and is running money against it internally. PIMCO has another firm manage it externally to maintain that separation and therein an unbiased weighting system. But even there you are dealing with primarily the GDP weighting driving things, and some of the other selection criteria are little trickier to pin down in terms of figuring out the best way to do it. So lot of those tend to be sort of equal-weighted things once you get down below the GDP level.

The problem is when you get down to sectors, how are you going to weight things like corporate bonds versus other sectors and so forth? That's where it becomes a lot more subjective and tricky, and as I said, it doesn't seem that anyone has really come up with a scheme that is widely accepted. However, you have had a couple of cases, including I think Research Affiliates, Rob Arnott's firm, doing some things with corporate bonds that look a little bit like fundamental indexes on the equity side, and it's sort of a waiting game to see what becomes popular there.

Benz: Eric, one last question for you. We have talked about Treasuries, but I also noticed Treasury Inflation-Protected Securities have had a pretty good runup recently. It doesn't seem like people are super concerned about inflation at the moment, though there have been some glimmers of inflation. What's driving the strength in that category?

Jacobson: It's very tricky because TIPS move around for lots of different reasons. Sometimes their prices go up because money flows into them as people anticipate inflation. Sometimes it happens in situations like this where it's just a fact of the real yield that they are offering starts to become so low and at the same time the regular Treasury bonds are so tight, if you will, that every little basis-point move after inflation returns starts to make the bond price a lot more sensitive. So when we get down to these low absolute levels, they tend to rally really hard with regular Treasuries.

The most important thing to understand, of course, is that even if we have some signs of rising inflation--and they do cause a sell-off among Treasury bonds and even though that may drive people to want to buy TIPS, if and when that happens--there is a very good possibility that during the short term TIPS will sell off wildly and probably lose even more than Treasuries. That's just something that people need to be aware of and concerned about, if they decide to load up too much thinking that the market's wrong right now about where we are heading.

Benz: Right. Eric thanks so much for sharing your insights. It's always great to talk to you.